W2: Lecture 5

Question 1

Categories of externalities

Answer 1

1. Production (firm–>others)
   *Negative –> Occurs when a firm’s production harms others without paying for it.
   ex. pollution

*Positive –> Happens when a firm’s production unintentionally helps others.
ex. infrastructure

2. Consumption (individual –>others)
   *Negative –> Arises when an individual’s consumption imposes costs on others.
   ex. traffic

*Positive –> When a person’s consumption improves others’ well-being.
ex. vaccination

Question 2

How does a negative production externality impact S&D equilibrium?

Answer 2

<slide 10 graph>
S(private costs) crosses D at the ACTUAL equilibrium

—> we include social costs

P increases and Q decreases
S-curve shifts parallel to the left-hand side.
Now we have the DESIRED equilibrium.

Question 3

What is the tragedy of the commons, and why does it occur?

Answer 3

It’s a situation where individuals overuse a shared resource for personal gain, leading to its depletion.
Occurs when the resource is rivalrous and non-excludable (e.g. clean air, fish stocks).
Without regulation, everyone acts in self-interest, harming the group in the long run.

Question 4

Common remedies for externalities

Answer 4

For negative externalities:
*Define property rights
*Taxes (Pigou tax)
(A Pigouvian tax is designed to make private costs equal to social costs by internalizing the externality, so that the person or firm causing the harm pays for it.)
*Quantity regulations
For positive externalities:
*Subsidies
*Quantity regulations

Question 5

Costs of negative product externalities: 3 questions

Answer 5

Q1: What “categories” need to be captured?
*extremely difficult to determine
*There’s a trade-off between completeness (impact) and simplicity (practicality).

Examples:
greenhouse gas emissions, air/water pollution, and biodiversity loss.

Q2: How should the “amount” in each category be calculated?
*Scope 1
–>DIRECT (reporting company)
ex. company facilities, vehicles
*Scope 2
–>INDIRECT (environmental impact?)
ex. purchased electricity and heat
*Scope 3
–>INDIRECT (Upstream & Downstream activities)
ex. purchased goods/services, transportation, use of sold products…

Q3: How could “costs per unit” of impact be determined?
*Requires valuation models to assign monetary costs to environmental/social impacts.

Examples:
Social cost of carbon (e.g., €100 per ton of CO₂).
Health cost per unit of particulate pollution.

*Methods include market proxies, shadow pricing, and life cycle impact assessments
–>extremely difficult to determine, uncertainty of discount rates and damages.

Question 6

What are the 6 steps to calculate the value of impact investing?

Answer 6

1. Assess the Relevance and Scale
   – Is the impact area meaningful and large enough? Is there a measure?
2. Identify Target Social or Environmental Outcomes
   – Define specific, measurable impact goals.
3. Estimate the Economic Value of Those Outcomes to Society
   – Quantify benefits in monetary terms.
   Find a robust “anchor study” and identify outcomes in economic terms.
4. Adjust for Risks
   – Account for uncertainty or potential failure to deliver.
5. Estimate Terminal Value
   – Include long-term impact beyond the initial timeframe.
6. Calculate Social Return on Every Dollar Spent
   Business: estimated value/investment
   Investor: Adjust for ownership stake
   – Express total impact as a return per $1 invested.